Rising balance sheet brings Fed closer to exit-plan overhaul

The central bank’s holdings expanded during the financial crisis as the Fed created several emergency loan programs. Chairman Ben S. Bernanke in November 2008 ordered the purchase of debt issued by housing agencies and mortgage-backed securities in a strategy that he called credit easing.

After the benchmark lending rate was cut almost to zero in December 2008, the Fed continued buying bonds as its primary easing tool. The Fed announced its third round of purchases in September without specifying a total quantity or end date.

Those central bank initiatives have helped push yields on Treasury and housing debt to record lows. The average fixed rate on a 30-year mortgage fell to 3.31 percent last month, according to a Freddie Mac index.

The yield on the 10-year Treasury note reached 1.39 percent on July 24 and, at 10:24 a.m. in New York, rose 0.03 percentage point to 1.62 percent after a report showed U.S. payrolls expanded last month more than forecast. U.S. Labor Department figures showed the U.S. added 146,000 jobs in November and the unemployment rate fell to 7.7 percent.

Transparency Push

The Fed announced the exit strategy in June 2011 as it sought to assure investors that it had the means to avoid igniting inflation once job growth, wages, and demand started moving up. The plan was part of Bernanke’s push for greater transparency and predictability.

The goal is to return the balance sheet to a pre-crisis size in two to three years and eliminate holdings of housing debt “over a period of three to five years.”

First, the Fed would allow assets to mature without being replaced, a process that will be slower now that the Fed has extended the average duration of its holdings. It would then modify its guidance on how long it plans to keep the federal funds rate near zero and begin temporary operations to drain excess bank reserves.

The Fed would next raise the federal funds rate, and finally, it would start selling securities.

The balance sheet averaged about 6.3 percent of nominal gross domestic product during the decade before the financial crisis. Today, a balance sheet of that size would be around $995 billion rather than $2.86 trillion.

Long Exit

“The exit is going to take a long time,” said Stephen Oliner, a resident scholar at the American Enterprise Institute in Washington and former Fed Board senior adviser. He estimates the Fed’s holdings could rise to more than $4 trillion.

If the Fed were to start bringing its holdings back to their pre-crisis level today, it would have to sell almost $2 trillion over a period of two to three years under its current exit plan. Assuming holdings grow to $4 trillion, asset sales could come to $3 trillion over the same period.

Fed officials haven’t publicly discussed an alternative plan for shrinking the balance sheet. One possibility, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, would be to enlist the help of the U.S. Treasury.